Flood Risk in the U.K.: What Does Mr. Market Think? (Part 3 The Information Game)

In my last post, we saw that the insurance industry has broken with the status quo because it realises that flood risk has entered into a new era. The stable frequency and loss distributions that underpinned their actuary-led calculations of the past are no more. The loss-related data that the industry laboriously collected in the past only gives insurers a limited ability to look into the future.

Nonetheless, if we only think of the pure insurance risk (as opposed to an insurer’s business model risk), insurance companies are really looking out only one year: when a home owner’s policy comes up for renewal each year, the insurer has the opportunity to change the terms and conditions of the policy including the premium and excess. And they could change the terms and conditions very aggressively—the equivalent of suspending coverage, just in disguise.

Given these factors, if an insurer can look out for that one year and capture a decent understanding of the risk, it should be protected from any massive loss event that blows it out of business. And if there is a big loss event and the insurance company is still standing, it can subsequently change the terms and conditions of the outstanding policies at the next yearly renewal including a hefty hike in the premiums.

Up until the floods of 2007, with their £3 billion-plus associated insurance pay-outs, the information in the hands of an insurer and a well-informed home owner would have not been that much different. Both would have had access (and still do have access) to the Environment Agency (EA)’s flood maps.

The flood maps are updated quarterly and give a risk assessment at the one in 100 and one in 1000 flood probability levels for river flooding (an EA pamphlet on the flood map can be found here). On top of this, the EA provides the insurance industry with the National Flood Risk Assessment (NaFRA) data. As mentioned in a previous post, this is more specific in terms of its flood risk categories (an EA pamphlet on NaFRA can be found here) and underpins the Statement of Principles agreement between the Association of British Insurers and the government. I will repeat the risk category definitions once again:

Low risk: the chance of flooding each year is 0.5 per cent (1 in 200) or less

Moderate risk: the chance of flooding in any year is 1.3 per cent (1 in 75) or less but greater than 0.5 per cent (1 in 200)

Significant risk: the chance of flooding in any year is greater than 1.3 per cent (1 in 75)

A home owner may have more interest in the one-in-75 risk (available from NaFRA) rather than the one-in-100 risk (available from the EA on-line Flood Map) since this is the demarcation point used to differentiate between ‘significant’ risk and ‘moderate’ risk, and as a result drives insurance premiums levels. Moreover, this risk demarcation point gives an some indication of what ‘significant’ risk property owners may be in for after the expiry of the Statement of Principles agreement expires in June 2013.

Fortunately, a risk assessment (called the Flood Risk Indicator, a description of which can be found here) based on NaFRA became available to the general public in 2009 through the Land Registry here and and costs £9 (although you can actually get the same information for free by contacting the EA directly). An example is below:

Now we need to recall the limitations of NaFRA, and accordingly the Land Registry’s Flood Risk Indictor:

The degree of granularity of the data is limited. NaFRA goes does to land area cell size of 100 metres by 100 metres, not down to an individual property

NaFRA is a frequency distribution: it says nothing of loss, and loss is principally driven by depth of flood, which is not covered by NaFRA

NaFRA does not cover surface water flooding

NaFRA does not cover groundwater flooding

NaFRA only looks at climate change that has taken place at the time of the survey date not beyond. So given the last NaFRA assessment was made in 2008, it is gradually going out of date

Because of the 2007 floods (when surface water flooding caused 50% of the flooding and 75% of the damage by value), the insurance industry has turned to the private-sector to fill the numerous holes in the Environment Agency’s risk assessment (NaFRA).

Against this background, a significant asymmetry of information has emerged between insurers and home owners. Until recently, either party could access the same flood risk data (although the insurance industry would have had its own loss data). Now, insurers are buying a whole range of data and analysis that home owners don’t get to see (at least without paying significant sums of money).

Specifically, insurers are purchasing data sets from such firms as JBA, RMS and Ambiental that a) give surface water risk, b) provide more detail than NaFRA’s 100 metre by 100 metre squares and c), in some case, offer predictions on potential depth of flooding. Moreover, ground water flood risk data is being made available by the British Geographical Survey (BGS) on a commercial basis here. Finally, firms such as Argyll Environmental have sprung up to provide consulting services that blend all the available information together.

To give you a sense of what insurers can potentially see, the image below is taken from a JBA submission to the MacRobert engineering awards. The level of detail is far and beyond anything in the Environment Agency’s flood maps.

Critically, with better data the insurers are in a position to calculate where policies within the Statement of Principles agreement with the government are being mispriced. A research brief by the ABI dated January 2011, gives us some numbers on the general underpricing of ‘significant’ risk properties (click for larger image):

And also how underpricing changes when frequency of flood worsens and the severity risk (as proxied by the height of the flood) increases:

The analysis above has an interesting hole: if ‘significant’ risk properties are being underpriced insurance premium-wise, then other properties are being overpriced. The £430 in the first table has to go somewhere, either as a burden on other property holders or as a drag on insurance company profits. Note also that the 124,000 properties are a sample, not the actual population of insured significant risk properties.

In reality, the industry has explicitly stated before that such underpriced risks are being parcelled out to property owners in low risk areas. This is one form of the socialisation of risk. Such actions, however, give rise to the problem of adverse selection. According to Wikipedia, the ABI covers 94% of insurance-related service provision in the U.K., but it is still worried that new entrants can cherry pick low or no risk householders by offering them policies that include none of the implicit subsidy in the policies offered by ABI members under the Statement of Principles.

But as we previously mentioned, the Statement of Principles says nothing about the size of premiums, level of excess and conditions of insurance policies. In short, it is a vague promise to be nice to property owners in significant-risk areas. In the ABI’s words:

It is important to note that the premiums charged and policy terms will reflect the level of risk presented and are not affected by this commitment.

So if you happen to live in a property at significant risk such as those in the Insurance Age article below, you basically are at the mercy of your insurance company’s forbearance.

And if the ABI wished, it could gut the Statement of Principles without actually cancelling it by hiking premiums and putting up excesses. However, it doesn’t want to go down that road. Why? Well, to be fair, the ABI may worry about the fate of the 200,000 or so ‘significant’ risk households (and counting upwards as climate change winds its merry way) that may lose access to flood risk insurance (and thus the ability to secure a mortgage loan) in the years to come.

And then again the industry may worry about the political risk. Mr Angry of Pangbourne, who we met in my first post, is in a deep funk. And I am sure he is already venting at one or more of his local council, district council, the Environment Agency and/or local MP.

As climate change progresses and the risk tools of the insurance companies improve, expect more Mr. Angry types to be created. Further, what will the collective noun of Mr Angry types do? Very likely pack together to become The Very Angry Owners of At-Flood-Risk Houses Association. Actually, they already have some outlets to collectively vent in the form of Know Your Flood Risk and the National Flood Forum (although the former has rather opaque roots and the latter was partially founded by the government and thus has the wisp of a Russian union organisation in the old Soviet era). However, I expect that as their numbers growth, and anger rises with each successive flood, they will become a much more irate political pressure group.

Against this background, let us turn to what the ABI is proposing post the expiry of the current arrangement in June 2013. The ABI’s submission to the UK parliament provides a nice summation here. At the core of the industry’s proposal is a not-for-profit flood reinsurance fund:

The fund would be a major improvement on the SoP (Statement of Principles) as it would deliver a competitive market where consumers have real choice whilst ensuring homes at risk of flooding are able to buy affordable flood cover. The fund would provide flood insurance for the 1- 2% (~200,000) properties in the UK where accessing flood insurance in an open market would be problematic. The remaining 98% of properties would continue to be covered by the industry as normal.

And to the important question of where the money for the fund would come from?

To make sure that the fund had sufficient money in it, insurance companies would make an annual contribution based on their level of premium income in the form of a levy raised from all insurance premiums. This would complement the income to the fund from the flood premiums from the high flood risk properties in the scheme.

This is not very different from the current arrangement under which ‘significant’ risk properties get an implicit subsidy from ‘low’ risk ones. But with a twist:

While the losses could be smoothed through reinsurance, in the event that not enough funds had built up in the first few years to cover a major incident like the 2007 floods, there would be a deficit needing to be met (effectively a need for an overdraft facility). Exceptionally large losses, such as a catastrophic North Sea tidal surge, may exceed this. We are currently discussing the model with the Government, and one of the key aspects of the negotiation is how we can work together to manage the liabilities of the scheme and raise the funds needed by the pool to operate, and well as the assurances insurers need about investment in flood defences to commit to the solution.

Now at first glance, this doesn’t look revolutionary. If the government is only extending an ‘overdraft facility’, then the industry could hike premiums following a 2007-type event and pay back the government. A problem arises, however, if a) 2007-type events start appearing with increasing frequency (which they likely will with climate change) or b) super 2007-type events occur (which they also probably will with climate change). Let’s say these super 2007-type events are equivalent in damage to a catastrophic North Sea tidal surge (which happens to be mentioned by the ABI above). The wording in the submission to parliament is suitably vague, but suggests that such events will produce losses above the government’s overdraft facility and……? They can’t quite bring themselves to say it, but I think the answer is pretty clear: the government picks up the tab.

So to recap, my previous post suggested that the insurance industry is grappling with frequency and severity distributions that have become unstable and have flattened out. So the industry’s overall loss distributions is growing a big, fat tail. The industry can only deal with this expanding tail by chopping it off. They can not extend insurance to the growing band of ‘significant’ risk customers—or bring in outrageously high premiums and excesses which is basically the same thing. Alternatively, they can give the tail to someone else, preferably the government.

Moreover, as the information asymmetry between householders and insurers has grown over the last 5 years, the industry now knows who is in the tail of negative outcomes (and who is likely to migrate into this tail over the coming years as climate change progresses)—while the vast majority of home-owners don’t.

In my final post, I will take a look at what happens to valuations on flooded houses and take a closer look at how climate change is making the risk pass the parcel game between home owners, the insurers, local councils and the central government ever more intense.